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Key decisions for asset growth

Net asset value of family farms

The ‘typical’ broad acre family farm now has a net asset value of near $5 million. Net asset value is comprised of land, water, machinery and livestock less bank and machinery liabilities. Net asset value has tripled over the last twenty years due to a combination of farm expansion and rising land and water values 

Net asset value of family farms

The ‘typical’ broad acre family farm now has a net asset value of near $5 million. Net asset value is comprised of land, water, machinery and livestock less bank and machinery liabilities. Net asset value has tripled over the last twenty years due to a combination of farm expansion and rising land and water values. 

KeydecisionsFigure1

Figure 1. Farm assets and liabilities, Victorian Mallee 1995 to 2016 (values at June) (Source: ORM data).

An analysis of farmland values, carried out by Rural Bank showed that for commercial farmland the 20 year average annual growth in the farmland median price is 6.4% nationally.

Average annual growth for the last five years (2011 to 2016) is listed for each state within Table 1 and for regions within Tasmania (Table 2).

Table 1. Five year average (2011 to 2016) of state capital growth in land values.

KeyDecisionsTable1

Table 2. Five year average (2011 to 2016) of capital growth in land for regions of Tasmania.

 KeyDecisionsTable2

 Key drivers of farmland value include:

  • Location
  • Farming system - enterprise mix.
  • Commodity price.
  • Climate - rainfall and seasonal events.
  • Economic confidence - interest rates, exchange rate, etc.

Return on capital (RoC)

Return on capital is measured as follows:

Business profit (income less costs) / Assets owned (land, water, machinery and livestock)

The main variable influencing RoC is business profit. RoC varies according to business profit and is typically in the range from -2% to 12%. The current five year average for the ORM database is 3.5% and has reduced from 4.5% in the previous five years.

Combined farmland investment return – capital growth and net income

Net income from farmland can be either:

  • Fixed – as with lease agreement (i.e. land rent less overhead costs). Lease rates typically 3 to 5% of farmland value; or
  • Variable – as with operating the land (i.e. Business profit as measured by RoC).

The combined farmland investment return from Tasmanian farmland is illustrated in Table 3.

Table 3. Combined Tasmanian farmland investment return (capital growth and net income) for the Top 20% and Average producers.

KeyDecisionsTable3

Productive farmland value

Productive farmland value refers to the relationship between farmland value and the income produced from that land.

For mixed crop and livestock land the productive farmland value can be calculated using assumptions as follows:

Income (I) equals 20% of total asset value (TAV)

or I = 20TAV/100.

Land and water (LW) are 80% of total asset value (TAV)

or LW = 80TAV/100.

Therefore income (I) is 25% of land and water asset value (LW)

or TAV=I100/20=LW100/80,

I=2000LW/8000 = 1/4LW = 25%LW.

These percentages will vary for each enterprise mix and region. Once confirmed then apply these to the 5 year average income to determine the productive value of farmland. For example, if average income across all enterprises is $1,000 per hectare then the productive farmland value is $4,000 per hectare.

If income is unknown then productive farmland value can be calculated using average yield and price for the main crop in that region. Using wheat as the example (Table 4), productive farmland value can be estimated as follows:

Table 4. Productive farmland value as estimated via average price and yield of wheat.

KeyDecisionsTable4

The above example suggests that 5.0 tonne per hectare cropping country generates $1500/ha (assuming wheat price of $300 per tonne), and therefore, has a productive farmland value of $6000 per hectare.

However there are a number of factors that can increase land value above its productive value. These typically add another 20 to 40% to the productive land value and include:

  • Suitability of land use to your preferred enterprises.
  • Efficiency, next door is worth more.
  • Distance to markets.
  • Financial strength of the buyer:
    • Current profitability.
    • Equity available as security.
    • Scale efficiency, i.e. utilise surplus machinery and labour.

When paying above the productive value then either ‘economy of scale’ or a subsidy from the existing business profit is needed.

The National picture – comparison of average rates of return for farmland across Australia

As demonstrated in Figure 2, the average rate of return for farmland is relatively consistent across the country. Tasmania has performed in line with the National average. The longer term 20 year average ranges from 9.3% in Victoria to 10.6% for Tasmania. The medium term 10 year average demonstrates some additional variation with the lowest result from South Australia at 4.9% compared to NSW at 8.1%. The results reported for the Northern Territory have been impacted by a data anomaly, the median price experienced a significant increase in 2016 of 35% (Table 5). This can be attributed to the composition of properties sold in that single 12 month period and is not necessarily reflective of performance of farmland across the state as a whole. This had a material impact on the 10 and 20 year averages for that State and will have had some influence on the National average. 

 KeydecisionsFigure2

**In the case of rural land the gross return has been calculated as the combination of average growth in the median price over the relevant period plus an assumed 4.0% operating return on capital. 

Figure 2. Gross average annual rates of return on Australian farmland (Source: Rural Bank, Ag Answers report - Australian Farmland Values 2016).

Table 5. Annual average growth in median price – National and State by State.

KeydecisionsTable5

Comparison to other investments

The National farmland average over 10 and 20 years has performed well against other investment assets in terms of average gross returns (Figure 3). 

KeydecisionsFigure2

**In the case of rural land the gross return has been calculated as the combination of average growth in the median price over the relevant period plus an assumed 4.0% operating return on capital. All other asset classes are reported gross returns over the relevant period 

Figure 3. Gross average annual rates of return on Australian farmland versus alternate asset classes (Sources: Rural Bank, Ag Answers report - Australian Farmland Values 2016; ASX, Russell Investments report – 2016 Long Term Investing Report).

The relationship between risk and return

The rates of return across the different asset classes should always be reflective of the risk profile of the asset class (Figure 4).

When investing in high risk investments, investors should expect above market returns to compensate them for the higher risk. Risk can be assessed as the volatility of the asset market, and the probability for variation from the expected return.

 KeydecisionsFigure4

Figure 4. Risk and return comparison (Source: ANZ, Fact Sheet – Asset Classes)

In the case of farmland, it assumes the risk profile associated with the property class of assets, this asset class includes commercial, industrial and residential property and listed property trusts.

Can high risk investments expect high returns?

The performance of the ASX200 over the past decade is an illustration of the volatility which contributes to the high risk profile of shares as an investment class.

In October 2007 the ASX200 Indicator was at 6,695. Shares were outperforming all other asset classes in respect to gross returns partly owing to the year on year increase in share values. By March 2009, 18 months later, the ASX200 had lost 49% of its value from the October 2007 peak.

Nearly a decade on in 2017, the ASX200 has not achieved the highs of October 2007 (Figure 5). Individually some shares have regained value and are performing well, however others continue to under-perform.

KeydecisionsFigure5

Figure 5. ASX200 Performance from October 2007 to current (Source: asx.com.au).

Priorities for investment

Consideration of investment options indicates that farmland returns are comparable to other investment options, and therefore, a financially logical option. Consequently the choice to invest in additional farmland will be determined by other factors such as the priorities and needs of the farming family. If farm scale expansion is the priority, then the capacity to invest in additional land will depend on:

  • Suitable land available for purchase.
  • Serviceability (Table 6):
    • Current profitability of existing business.
    • Forecasted profits with new land included.
  • Security:
    • Debt to land asset available as security.
    • Financiers lending ratio guidelines.
  • Adequate capacity of resources:
    • Machinery.
    • Labour.

Table 6. Serviceability indicators

KeyDecisionsTable6

There are also additional ‘business health check’ guidelines that should be considered prior to purchasing additional farmland and these are listed in Table 7.

Table 7. Business health check indicators.

KeyDecisionsTable7

However there may be a preference for investment outside the farm. Off-farm investment can be a priority where there is a need to create wealth separate to the farm to provide for:

  • Retirement, financial independence.
  • Succession to off-farm children.
  • Diversification of asset investment.
  • Desire for passive investment (reduce workload).

Business life cycle

Ideally, growth in equity ($) over a 25 year business cycle should follow the pattern as illustrated in Figure 6. The stages along the business life cycle have different priorities for profit allocation and have different performance benchmarks. 

KeydecisionsFigure6

Figure 6. The business life cycle which shows the key stages over time and the key financial focus of the business during the stages i.e. building cashflow, investing in business growth and building financial buffers to assist future transition.

Investing the profits to create longer term wealth

The business life cycle helps to understand the changing priorities as individuals mature in business. When starting off (emerging/growing stage) the best use of profits is not necessarily to reduce debt, rather profits will likely be allocated to build equity through machinery and livestock, and to grow scale for the business. Then as the business consolidates and matures the focus can shift to debt reduction and to investments for retirement planning and the provision for the non-farm children.

Allocation of profits needs careful planning and is best done with consultation from all members of the business.

A key to successful business growth is the use of planning meetings focused on the strategic direction of the business. These can be attended by all the business and family members and they provide an opportunity to review the business’s direction and set priorities for asset growth and profit investment.

A viable scale for the next generation

Indicator guidelines can be used in reverse to calculate a viable scale for an ‘emerging/growing’ farming family.

The scenario detailed in Table 8 can assist when setting goals for generational transition or for business growth to include additional labour units.

If the next generation family goal is to have $115,000 available for living, school fees, tax and debt repayment then the guidelines as provided in Table 8 can be applied to determine the asset value necessary to sustain a family unit at their targeted income.

The following assumptions are made for the calculations detailed in Table 8:

  • Surplus is 8% of income.
  • Costs as % of income are:
    • Overheads (rates, insurance, prof. fees) - 8%
    • Farm inputs (fertiliser and sprays, seed, etc.) - 30%
    • Machinery (fuel, repairs, contracting, capital replacement) - 28%
    • Finance (interest, bank fees and rent) - 11%
    • Labour (own living, school fees, casual employees) - 15%
  • Income is 15% of current asset value (land, water and machinery).
  • Value of machinery is the same as annual farm business income.

Table 8. Viable scale for an ‘emerging/growing’ farming family.

 KeyDecisionsTable8

The example illustrated in Table 8 confirms that the next generation requires a significant asset contribution from the older generation if they are to achieve a viable scale. Examples of how this can be achieved are:

  1. Lease their parents’ land to the value of up to $2.8 million with a subsidised land rental.
  2. Transfer land of up to $2.8 million from the parents to the on-farm child with a payment to the parents of $900,000 which can be quarantined as an asset for the non-farm children.
  3. Purchase new land with some equity contributed by the parents. Total debt, both internal to parents and external to bank not exceeding $900,000.
  4. Combinations of the above.

The parents’ preference for asset ownership determines whether land is transferred or ownership is retained by the parents. If ownership is retained then the commencement of financial independence for the next generation can be through the future growth of the family business. For example, future land purchases can be in the name of the next generation with debt repaid through the family trading entity.

There are many variations on how the next generation can transition into a viable farming business. The best option for each business is dependent on the needs and preferences of the parents, then the next generation.

Conclusion

Farmland operators are achieving good returns from owning and working farmland. These returns are comparable to alternative investments.

Profits generated from farming the land provide the key to future sustainability of the business. The growth in capital value in farmland is the passive contribution underlying the business profits.

References

Rural Bank, Ag Answers report - Australian Farmland Values 2016 https://www.ruralfinance.com.au/uploads/aga_documents/australian-farmland-values-report-2016.pdf

 ASX, Russell Investments report – 2016 Long Term Investing Report. http://www.asx.com.au/documents/research/russell-asx-long-term-investing-report-2016.pdf

More information

Phil O'Callaghan

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The information in this paper is general in nature and should not be taken as personal professional advice. Readers should seek their own independent advice from a qualified adviser and not rely solely on the general nature of information in this paper.